Marijuana, also called "cannabis," is partly or wholly legal in a majority of states. Medical marijuana, which you need a doctor's prescription to obtain, is legal in 34 states. And, in a growing national trend, 18 states have legalized recreational marijuana—that is, the use of a specified amount of marijuana for any purpose without a prescription.
Thousands of marijuana dispensaries legally operate in the United States. However, marijuana is still technically illegal under the federal Controlled Substances Act. As a result, marijuana businesses are treated very differently from other businesses for federal income tax purposes. A special provision of the tax code enacted in the 1970s bars tax deductions for business expenses incurred in the business of illegal trafficking of drugs listed in the Controlled Substances Act. (IRC Section 280E.) (Ironically, deductions are still permitted for other illegal businesses, such as prostitution and contract killing.)
The law was intended to stop drug dealers from claiming tax deductions, but the IRS says it applies to marijuana dispensaries as well. It has audited several major dispensary owners and denied them deductions for their business expenses, such as rent, advertising, depreciation, legal fees, wages, utilities, and security services. In some cases, the IRS has demanded that the audited dispensaries pay millions of dollars in back taxes.
The Tax Court has upheld the IRS's actions. In one case, for example, the Tax Court unanimously found that the owner of the Vapor Room Herbal Center, one of San Francisco's largest and most profitable dispensaries, was not allowed to take business deductions because the business was trafficking in a controlled substance. (Olive v. Comm'r, 139 T.C. 2 (2012).)
However, Section 280E applies only to bar deductions or credits that are taken against gross income. This means that marijuana dispensaries are allowed to deduct the cost of the goods because, technically, this is not a business deduction; rather, it is subtracted from gross receipts in determining a taxpayer's gross income. Thus, a dispensary owner may deduct the cost of purchasing marijuana from growers. The IRS says that marijuana dispensaries may deduct: (1) the invoice price of purchased marijuana from the producer, minus any trade or other discounts, and (2) the transportation costs to obtain the marijuana.
Marijuana producers may also deduct their costs of goods sold, and they get more such deductions than dispensaries. Producers may deduct:
Another way marijuana dispensaries have attempted to avoid Section 280E is to claim to operate more than one business for tax purposes: a marijuana business and a non-marijuana business. The expenses of the non-marijuana business should be fully deductible.
In one case, for example, a dispensary successfully argued to the Tax Court that it effectively had one business selling medical marijuana and a second business giving care to patients. The director of the dispensary was an experienced health professional. He operated the dispensary with caregiving as the primary feature and the dispensing of medical marijuana (with instructions on how to best consume it) as a secondary feature. The court held he could deduct his expenses for the caregiving business. (Californians Helping to Alleviate Med. Problems, Inc. v. Comm'r (CHAMP), 128 T.C. 173 (2007).)
However, other dispensaries that have tried to use this tactic have not been successful. For example, the Tax Court held that a separate corporation set up by a marijuana dispensary to provide human resources services for its employees was not a separate business. (Alternative Health Care Advocates v. Comm'r, 151 T.C. 13.) Likewise, there was no separate business where a dispensary sold books, T-shirts, and other items in addition to marijuana. The court ruled the sales were only incidental to the dispensary's business of selling marijuana and not a separate business. (Canna Care, Inc. v. Comm'r, 2017-2 U.S.T.C. ¶50,289.)